Avoiding mistakes is just as important to portfolio performance as picking winners. And sometimes the market warns advisors that something isn’t right. Unfortunately, these red flags might be misinterpreted as opportunities, leading investors into a trap.

For example, when a company’s shares are yielding 10% to 12%, that often indicates the market expects a company’s dividend to be cut, rather than representing a prospect for solid income. Similarly, a discount to net asset value (NAV)—when the active share price of a company is trading at less than the calculated NAV per share—can be a warning sign as much as an opportunity. Some research reports identify discounts to NAV as a positive, and we’ve seen many in the last year highlighting the appeal of discounts in the range of 20% to 40%.

Susceptible sectors

The discussion of discounts to NAV comes up most frequently in the REIT and materials sectors, and with public companies that have stakes in numerous investments (e.g., holding companies and private equity firms).

Unfortunately, accounting tends to lag reality and NAVs can be inflated if the assets on company balance sheets are overvalued, or have not been written down to reflect a fundamental impairment in value. A number of factors can cause a disconnect between the amount reported on the balance sheet and the fair market value of the assets.

Sometimes executives overstate the value of their company’s assets due to the endowment effect (see AER November 2015). The same psychology can lead management to delay recognizing impairments, with some studies showing that the lag between impairment and recognition can be more than two years.

Aside from psychology, two other factors can conspire to cause NAVs to be overstated: IFRS accounting rules, which generally facilitate the application of significant management judgment and delay; and the slow manner in which external assessments are used to corroborate the value of assets. Here’s a breakdown.

IFRS permits value in use Value in use is an obscure accounting notion where management has the ability to value an asset at a much higher amount than any other entity would pay for it. Value in use lets management assume that it has knowledge of its own assets that the market is not aware of or cannot fully appreciate. In other words, the amount reported on the balance sheet might be higher than what would result from a third-party sale of the assets, and therefore should not be used in comparison to share price.

External inputs are lacking Management generally estimates and reports the value of its assets every quarter, but only seeks third-party help every few years. In a flat real estate market, it makes sense to keep costs down. But, in a volatile market like Canada’s over the past 18 months, it has become a substantial investment risk.

Consider a REIT that has significant exposure to Western Canada. It’s possible that only one-third of the company’s property portfolio was subject to an external appraisal as of the latest year-end.

What is net asset value?

NAV is a fairly straightforward notion. It reflects the balance sheet value of a company’s assets, minus any liabilities, on a per share basis. When something is trading at a discount to NAV, it’s often regarded as an opportunity because investors assume that irrational prices will eventually revert to their mean. There are normal investment risks involved in this belief, including that there is no guarantee that the shares will ever trade up to the stated value of the assets. But there are also underappreciated accounting risks—mostly that the value of the assets might not be what is reported in the financial statements.

That means two-thirds of the portfolio was valued in 2014 and prior, when oil prices hovered close to $100 per barrel. Since that time, a crash in energy prices, and the economy in general, has seriously impaired real estate values.

Given the lack of external input, and the delay that management can exhibit in writing down the assets, the existing values on some balance sheets could be seriously overstated, which would explain any discount exhibited by the share price.

Beware of anchors

Sometimes analysts will provide supporting methodologies in determining their target prices. So advisors should be aware of another psychological effect. It goes by different names, but essentially it’s an anchoring effect whereby an analyst arrives at the same result via different means to support her initial conclusion. For example, an analyst might conduct a discounted cash flow analysis, or net operating income forecast. But, in so doing, she chooses inputs that drive the results to the same conclusion as the initial analysis of the discount to NAV.

Warning signs

Avoiding the discount-to-NAV trap is not easy. Advisors can cut down their chances of making a mistake by not ignoring factors like geographic overconcentration, higher levels of intangible assets, increased leverage, significant levels of private or illiquid investments, and direct and indirect exposure to energy assets.

Analysts might ignore these reasons in order to support their initial or previous analyses. But advisors can watch for these anomalies, and recognize them for the clear risks they are.